On November 15, 2011, the U.S. Internal Revenue Service ("IRS") and the U.S. Department of Treasury ("Treasury") issued final regulations under Section1 108(e)(8) and certain other Sections relating to the application of Section 108(e)(8) to partnerships (collectively, the "Final Regulations"). The Final Regulations address how to determine the amount of a partnership's cancellation of indebtedness ("COD") income when the partnership issues an interest in itself to a creditor in satisfaction of the partnership's debt, and the tax treatment to the creditor that exchanges its debt of the partnership for an interest in such partnership, emphasizing that the creditor generally would not obtain a deduction if the amount of the debt exceeds the fair market value of the partnership interest received. The Final Regulations also address how a partnership's COD income is allocated as minimum gain chargeback. In addition, in conjunction with the Final Regulations, the IRS and Treasury have advised that they will issue proposed regulations addressing the contribution of an installment obligation of the partnership to the partnership under Section 453B. The Final Regulations took effect November 17, 2011, the date that they were published in the Federal Register.
Section 108(e)(8)(B) provides that if a debtor partnership transfers a capital or profits interest in itself to a creditor in satisfaction of a recourse or nonrecourse debt, the partnership is treated as having satisfied the debt with an amount of money equal to the fair market value of the partnership interest transferred to the creditor (the "Exchange"). The partnership recognizes COD income to the extent the amount of the debt exceeds the fair market value of the partnership interest transferred. Any COD income (subject to the application of the bankruptcy or insolvency exception at the partner level (or other exception)) is included in the distributive shares of the partners who were partners in the partnership immediately before the discharge.
Valuation of the Partnership Interest Transferred in Satisfaction of Partnership Debt
In general, similar to the proposed regulations, the Final Regulations provide that all the facts and circumstances must be considered in determining the fair market value of the partnership interest transferred, which should include future shares in profits and losses and certain non-economic factors such as restrictions on transfer and/or management rights. However, like the proposed regulations, the Final Regulations provide a safe harbor method for determining the fair market value of the partnership interest transferred (even if the fair market value is readily ascertainable) by allowing a partnership to use the liquidation value of the transferred interest (the "liquidation safe harbor"). For this purpose, the liquidation value equals the amount of cash that the creditor would receive with respect to the partnership interest transferred in the Exchange if, immediately after the Exchange, the partnership sold all of its assets (including intangibles) for cash equal to the fair market value of those assets and then liquidated. Although fair market value of a partnership interest may differ significantly from liquidation value of the interest, we believe that the liquidation methodology should prevent unnecessary costs and burdens on the parties involved in determining the fair market value of the partnership interest transferred.
The liquidation safe harbor provides that the fair market value is equal to the liquidation value if the following requirements are satisfied :
- The creditor, partnership and its partners treat the fair market value of the debt as being equal to the liquidation value.
- If, as part of the same overall transaction, the partnership transfers interests in itself to multiple creditors, then each creditor, the partnership and its partners must treat the fair market value of each respective partnership interest as equal to its liquidation value. The proposed regulations only required that each Exchange between a creditor and the partnership satisfy this requirement. The Final Regulations were revised to prevent taxpayers from selectively exploiting to their benefit the discrepancy between liquidation value and fair market value.
- The Exchange is a transaction that has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests. This requirement clarifies the requirement in the proposed regulations that the liquidation safe harbor is available to related parties so long as the requirement in the preceding sentence is satisfied.
- Subsequent to the Exchange, the partnership does not redeem the partnership interest transferred in the Exchange and no persons related to the partnership or partner (as provided in Sections 267(b) and 707(b)) purchase such partnership interest as part of a plan at the time of the Exchange that has as a principal purpose the avoidance of COD income by the partnership. This requirement is an anti-abuse provision.
The Final Regulations also clarify that the liquidation value of an upper-tier partnership that directly or indirectly owns an interest in one or more partnerships (lower-tier partnership(s)) is determined by taking into account the liquidation value of such lower-tier partnership interest(s).
Application of Section 721 to an Exchange
Generally, under Section 721(a), a partnership and its partners do not recognize gain or loss upon the contribution of property to the partnership in exchange for a partnership interest. The Final Regulations generally extend this approach to a creditor's contribution of partnership debt to the partnership in exchange for an interest in the partnership (capital or profits), except (i) to the extent of any COD income as provided in Section 108(e)(8)(B) and (ii) to the extent that the transfer of the partnership interest to the creditor is in exchange for the partnership's debt for certain ordinary income items, such as unpaid rent, royalties or interest (including accrued original issue discount) that accrued on or after the beginning of the creditor's holding period for the debt.2 The Final Regulations provide that Treasury regulation sections 1.446-2 and 1.1275-2 apply to determine whether a partnership interest transferred to a creditor is treated as a payment of interest or accrued original issue discount, respectively. Those Treasury regulations state that payments made to a creditor should generally be applied first to payments of accrued unpaid interest (or original issue discount, as the case may be) and then to the outstanding principal on the debt. The debtor partnership, however, will not recognize gain or loss under such circumstances.
This means that the creditor generally will not receive a deduction if the amount of the debt exceeds the fair market value of the partnership interest received. In this case, an asymmetrical result occurs between the creditor and partnership because the creditor will generally not be able to obtain an immediate deduction (instead the creditor's tax basis in the partnership interest equals the tax basis in the cancelled debt) and the creditor may suffer a character conversion from an ordinary loss to capital loss. Nevertheless, the partnership will recognize COD income to the extent that the amount of the debt exceeds the fair market value of the transferred partnership interest as determined under the Final Regulations.
COD Income as First-Tier Item for Minimum Chargeback Rules
The Final Regulations provide that COD income arising from a discharge of partnership or partner nonrecourse debt is treated as a first tier item for minimum gain chargeback purposes.
Disposition of Installment Obligations
Section 453B generally provides that the dispositions of installment obligations is a taxable event. Treasury regulation section 1.453-9(c)(2) provides, however, that the contribution of an installment obligation to a partnership under Section 721 is not a disposition for this purpose. In the preamble to the Final Regulations, the IRS and Treasury state that this exception, consistent with the corporate context, should not apply to a creditor who disposes of an installment obligation of a partnership by contributing it to the debtor partnership in a Section 721 transaction. The IRS and Treasury note that the creditor must recognize gain or loss under Section 453B and advise that they will issue proposed regulations to clarify this issue.
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